One of the most crucial considerations a real estate investor can make is choosing the right ownership structure. The tax implications of the structure that they choose can significantly impact their balance sheet. You can discover your tax savings and find out more about tax-efficient ownership structures for real estate investors.
Choosing the right structure
Before exploring the different types of structure options, let’s take a look at some factors that may help decide which structure is best. Some key considerations include the investor’s financial goals, the type of real estate investments, and the desired level of control.
For example, it is important to clearly define your tax goals. Figure out whether they involve minimizing current tax liability, maximizing deductions, or planning for long-term capital gains treatment before you do anything. Then consider the level of liability protection needed. Certain structures provide a shield against personal liability, while others expose the investor’s personal assets to risks taken by the business.
It is also important to assess the flexibility required for the business as well as the long term strategy. Some companies offer a high degree of flexibility in terms of taxation, management structure, and ownership which makes them a popular choice among real estate investors. Structures that facilitate tax-deferred exchanges and capital gains treatment are likely to be preferable for those planning to keep properties for a long period of time.
Lastly, if estate planning is a consideration, structures like family partnerships or LLCs can offer tax advantages and facilitate the smooth transfer of assets to heirs.
This is by far the most simple form of ownership and involves an individual owning and operating the real estate business. This provides the investor with complete control, but at the same time, exposes the investor to personal liability. It is also not the most tax-efficient option as income generated is taxed at the individual’s tax rate, and there are limited opportunities for deductions compared to other structures.
Partnerships are one of the more popular choices for real estate investors as they offer both flexibility and shared responsibilities. In a general partnership, income and losses flow through to the individual partners which helps them avoid double taxation. Limited partnerships and limited liability partnerships provide liability protection for some partners while still allowing favorable tax treatment.
Limited Liability Company (LLC)
An LLC gives investors the liability protection of a corporation and the flow through taxation of a partnership. Members therefore get to enjoy limited liability, and income or losses pass through to individual tax returns. This makes LLCs a tax-efficient choice for real estate ownership and therefore is a widely used option. Investors can choose to be taxed in a few different ways. They can either be taxed as a disregarded entity (for single-member LLCs), a partnership, an S or C corporation, depending on their specific tax strategy.
An S corporation is not a stand-alone entity like an LLC or corporation and is often chosen for its pass through taxation benefits. Profits and losses pass through to shareholders’ personal tax returns and therefore avoid corporate-level taxation. S corporations do however have strict eligibility criteria. Things such as a limit on the number and type of shareholders, as well as the fact that all shareholders must be US citizens or residents that are used to determine eligibility.
These are not as common for real estate investments but they may be suitable in certain situations. These kinds of corporations are subject to double taxation as profits are taxed at both the corporate level and again when distributed to shareholders. The benefit being that they offer lower corporate tax rates and may be advantageous for investors who are holding properties for the long term.
Real Estate Investment Trust
A Real Estate Investment Trust is an ownership structure that has been specifically designed for real estate investment. These allow investors to pool funds to invest in a diversified portfolio of real estate assets. At least 90% of taxable income must be distributed to shareholders. Investors therefore receive dividends, and the Trust itself avoids corporate-level taxation.
Tenancy in common
In this kind of structure, more than one investor co-owns a property and each one has a fractional interest. This provides investors with a tax-efficient way to pool resources and share ownership and doesn’t have the formalities of a partnership. Each investor will report their share of both income and expenses on their individual tax returns which allows for personalized tax planning.
Family LLC or Limited partnership
These types of structures are often used for estate planning and wealth transfer. They allow for the transfer of real estate assets to family members while maintaining control. The senior generation can therefore retain management control while at the same time giving limited partnership interests to their heirs.
Selecting the right ownership structure is therefore a critical decision with significant tax implications. Each structure comes with its own set of benefits and considerations and one must consider what the overall financial goals are before deciding on the best structure to use. Real estate investors should work closely with tax professionals and legal advisors to tailor the ownership structure to their specific needs.